Term deposits versus inflation linked bonds - we assess the best picks

The three types of bonds available - fixed rate, floating rate and inflation linked - offer compelling protections that term deposits do not

Key points:

Inflation linked bonds (ILBs) are the only security that offers a 100% hedge against inflation and should be a core holding of most retiree’s portfolios.

ILBs offer a range of benefits that term deposits do not, including: returns linked to inflation, more frequent interest payments, liquidity through secondary bond markets and the opportunity for higher than expected returns.

Senior ranked ILBs offer very attractive yields of up to 2.5% over the best term deposit rates given annualised inflation of 2.3%.

Low term deposit rates of 3.5% or less mean investors’ real return (the rate over and above inflation, currently running at 2.3%) is, at best, just over 1%.

Current real returns on investment grade inflation linked bonds can provide a real return approaching 3%, providing protection and an attractive return in this low rate environment. Differences between term deposits and inflation linked bonds include:

1. Returns on inflation linked bonds rise as inflation rises

Most term deposits pay a fixed rate return. If inflation starts to rise, investors have to wait until maturity to seek higher returns. They can break the agreement but that usually involves a break fee or loss of interest earned.

Inflation linked bonds pay interest linked to the Consumer Price Index (CPI) and are adjusted quarterly. If inflation starts to rise, the returns on these bonds also rises to compensate. Inflation linked bonds are the only investment to provide a 100% hedge against inflation.

2. Interest is paid quarterly for most inflation linked bonds

Interest on most term deposits is paid at maturity, although if the term exceeds 12 months, it is usually paid annually. Banks will pay more frequent interest but the interest earned is usually reduced to compensate.

Inflation linked bonds usually pay quarterly interest, great for those investors wanting cashflow to meet expenses.

3. Liquidity – the ability to access your funds

Term deposits are not liquid investments; investors agree to forgo access to those funds for a pre-determined period. If investors want to access their funds then their overall return is reduced.

Bonds are generally liquid investments, that is, can be easily bought and sold in the secondary market, where they are actively traded. Even though many inflation linked bonds have long maturity dates, there is no requirement to hold bonds until maturity.

4. Bonds offer the opportunity for higher than expected returns

Term deposits are not tradeable securities and there is no secondary market, which means returns cannot exceed expectations.

Because there is an active secondary market for bonds, their prices can fluctuate. Bonds can trade at a discount (below the price they were first issued) or at a premium (above the price they were first issued). Meaning there is an opportunity for bond prices to rise and investors to sell and take profits. A loss is also possible if investors sell before maturity.

As FIIG trades some bonds in $10,000 parcels, holders of higher value parcels, say $50,000, can sell down their holdings in $10,000 lots.

5. Better returns for a marginal increase in risk

Inflation linked bonds are issued by a wide variety of institutions. Commonwealth and state governments are very low risk issuers. Corporations also issue inflation linked bonds offering a range of risk and reward options.

Most corporate ILBs are senior debt, ranked lower in the capital structure than term deposits. By taking additional risk, inflation linked bonds generally offer higher returns than term deposits.

Below is a sample of inflation linked bonds (Table 1 shows capital indexed bonds and Table 2 indexed annuity bonds) with real yields in some cases over 3% (see the running yield column). In comparison, the best one year term deposit rates are around 3.5% but provide no compensation for inflation.

Capital indexed bonds (CIB)

Table 1

The Sydney Airport 2020 and 2030s inflation linked bonds remain ongoing favourites. The high real yields the bonds offer coupled with monopoly leasehold assets and the fact Sydney Airport accessed the US private placement market last year (showing good access to diverse funding sources) mean we are very comfortable with the risk/return analysis.

The Ale Finance CIB (ALE) is another very good relative value proposition, although it rarely becomes available. ALE is Australia's largest listed freehold owner of pubs. Established in November 2003, ALE owns around 90 pubs. All of the pubs are leased to members of Australian Leisure and Hospitality Group Limited (ALH) which is 75% is controlled by Woolworths.

Table 2

The IABs are very high credit quality and offer similar yields to maturity. In January the MPC (Melbourne Convention Centre) offered the best relative value, but there is no longer any one security that I think offers stand out value. The yields are more indicative of the term to maturity. If you run your eye down the table you’ll see the yield generally increases as the time to maturity increases.

A brief description of MPC (Melbourne Convention Centre)

MPC is the funding arm of the Melbourne Convention Centre development consortium and represents a low risk infrastructure investment with the inflation hedging benefits of inflation linked bonds.

The original funding method used to develop the Convention Centre was via a Victorian government backed Private Public Partnership (PPP) with the Plenary Group Consortium (PCPL), who were engaged to design, construct and manage the facilities of the Melbourne Convention Centre. The convention centre consists of a 5,000 seat plenary hall, a 1,500 seat banquet hall, conference and meeting facilities and more than 2,800 car parking spaces.

Upon completion of the construction phase of the project, management moved on to the lower risk facilities maintenance phase. The facilities maintenance contract covers cleaning, security, asset maintenance and the management of car parking. In return for providing the contracted services PCPL receives a quarterly service payment from the state government. As a result, around 98% of PCPL’s revenues will come from the Victorian government.

Summary

Term deposits are an important defensive investment. However, inflation linked bonds provide important protections that term deposits do not and should therefore be included in every portfolio.

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